Netflix Could Reach $130 By 2013

Netflix (NASDAQ:NFLX) is a subscription-based content provider offering movies and television shows via postal delivery on DVD and via Internet streaming. The recent uptick in consumer confidence and a better employment picture are making Netflix's future look brighter. Meanwhile, consumers are still cutting back on outside entertainment like dining out and going to the movies, while holding onto lower cost "home comforts" like movie rentals. In this article, I will discuss how Netflix could shape up to be a very lucrative investment over the next eight to 12 months.

While the company proved a killer of traditional brick-and-mortar retail rental operations like Blockbuster and Hollywood Video, it raised a firestorm among its subscribers in 2011 when it announced separate subscription fees for its DVD-by-mail and Internet streaming services. Its original base plan price had been $9.99 per month ($7.99 for unlimited streaming content plus $2 for one DVD at a time); the new plan created two separate services, each $7.99 per month. The move generated a strong wave of consumer anger and a backlash that ultimately cost the company about a million of its 25 million subscribers Though CEO Reed Hastings subsequently apologized for how the change was handled, Netflix did not budge on its new pricing model. From a peak of $298.73 on July 13, 2011 - just days after the new plan was announced - Netflix's share price began a steady decline that took it to $128.50 by September 21, and below $100 by late October, where it languished until late January.

Now, however, Netflix looks to be making a strategic move into what used to be enemy terrain: cable systems. Cable operators have long considered Netflix a rival, fearing that consumers might opt for $7.99 a month to stream movies and TV shows over a laptop, web-capable TV, Internet-connected Blu-ray player, or even a Roku instead of paying premium prices for cable subscriptions. So far that fear has not materialized, mostly because Netflix offers a relatively limited content (though that content does change periodically).

Reuters announced March 6, that Netflix has held meetings with "some of the largest U.S. cable companies" to consider the possibility of adding Netflix as an on-demand offering. That would potentially make the subscription just another add-on to a consumer's cable bill. Netflix's Hastings has proposed that the company might ultimately compete with the likes of HBO, and in fact it premiered its first original show, Lilyhammer, in February, with a second series announced a few days later.

Cable companies have reacted in various ways to Netflix. Time Warner (NYSE:TWX) was dismissive, with CEO Jeff Bewkes once equating Netflix's threat to that posed by the "Albanian Army." Comcast (NASDAQ:CMCSA), on the other hand, launched its own streaming service, Streampix, in February, so it apparently considers Netflix dangerous enough to be worth imitating. Verizon (NYSE:VZ) has entered a joint venture with Redbox, a subsidiary of Coinstar (NASDAQ:CSTR), that will commence later this year.

One of the most significant threats for Netflix - and any company that offers streaming video, for that matter - is the move toward charging for Internet service based on bandwidth usage. While wireless networks are the first priority of such moves, Internet service providers are not far behind. The catch: the major providers of high-speed Internet service in the U.S. are cable operators - some of the same companies that Netflix competes with. Since video streaming tends to be a bandwidth hog, such a move would be directly counter to Netflix's interests.

One little-discussed aspect of Netflix's business model is its proprietary system for matching customers to movies they might like. This enables it to promote viewership of older titles (whether via DVD or streaming delivery) and thereby reduce its operating costs.

For fiscal 2011, Netflix reported sales of $3.205 billion versus $2.163 billion for 2010 with net income (after taxes) of $226 million. The company has seen consistent and substantial increases in both revenue and income going back to 2007. Netflix also has a great cash flow position, and one that looks exactly as you would expect for a young company, improving from ‒$223 million in 2007, to turn positive at +$60 million in 2010, and increasing to +$314 million in 2011.

As for future prospects, the subscriber losses that resulted from its 2011 price changes have ended, and Netflix has expanded into the Canadian and Latin American markets, as well as Ireland and the U.K. at the beginning of 2012. While these moves will drive revenue, there will also be expenses associated with entry into four new markets, so margins are likely to be squeezed for 2012.

Peer comparisons for Netflix are a bit complicated simply because it falls into the Internet Retail sub-industry, which puts it alongside such companies as Amazon (NASDAQ:AMZN), Overstock (NASDAQ:OSTK), Expedia (NASDAQ:EXPE), and Priceline (NASDAQ:PCLN) that have substantially different business models. Its overall industry group is Consumer Discretionary, which is also quite broad. As such, we'll look at some straight numbers instead of potentially-misleading peer comparisons.

Netflix had a gross margin for the trailing twelve months (TTM) of 36.34% and a net profit margin of 7.06%. Its debt load for the most recent quarter (MRQ) was 0.6, held almost entirely in long-term debt. Management effectiveness indicators were positive, with return on assets of 11.16%, return on equity of 48.47%, and return on investments of 18.55%. The company does not pay a dividend.

It has no directly comparable competitors, though as we have already explored, it does compete in some respects with cable operators. Its most significant competition comes from companies that offer streaming video, like Amazon, Apple, and Google, and from alternative DVD rental sources like Redbox.

Amazon offers video streaming of movies and TV shows, and made significant inroads into that market with the introduction of the Kindle Fire. Fire owners who are also Amazon Prime members have the option to stream content free (Prime membership is currently $79 per year, which compares favorably with Netflix rates) on their device, and the Fire's low price ($199) compared with the iPad makes it clear that Amazon intends to make money on content, not hardware. Since the Fire works exclusively off the owner's home wireless Internet, Amazon would suffer the same effects from use-based pricing by Internet service providers.

Apple sells content through its iTunes store. Its Apple TV device, which allows the display of streaming Internet content on the user's TV, competes more directly with Roku, and in fact Netflix is one of the options that is advertised for Apple TV. As with any other streaming service, this content would be affected by bandwidth throttling or usage charges.

Google (NASDAQ:GOOG) offers a video streaming service to Android devices through the Android marketplace, a service it introduced in 2011. While Google is not known as a content provider in the same way that Apple and Amazon are, it is also a 600-pound gorilla in the Internet marketplace and could provide yet another distraction (or obstacle) for Netflix.

Redbox, owned by Coinstar , provides an alternative pay-by-use DVD rental model. Though it recently raised rates to $1.20 for standard DVD rentals from $1, its rental kiosks are widely distributed and make impulse rentals very easy and inviting. Some industry observers expect the DVD to fade away eventually, making it an obsolete part of even Netflix's business model one day, but at the moment Redbox offers another option for those customers who do not typically rent more than four or five DVDs a month. It can even stand as a complement to Netflix subscribers who opt solely for the streaming content option.

Current short interest in Netflix is 20.42% of float, which is about seven times the 2.84% rate for its peer group. The quantity of shares short has held very stable since last month, so clearly someone anticipates a drop in share price. However, I think that Netflix is currently undervalued and oversold. Though it will certainly take a hit to earnings in the first quarter from the costs of entering new markets, over the longer term the new subscriber base (keep in mind that the company attracts new customers with a free first month) will drive additional revenue.

As part of the Consumer Discretionary group, Netflix would stand to suffer in the event of negative economic news, and a continued run-up in the price of oil could force some customers to choose between gas in the car and little luxuries like Netflix. However, the employment picture remains encouraging thus far, and consumer confidence is picking up, so Netflix should not suffer negative effects from the macroeconomic environment in the foreseeable future. Moreover, during the last recession, many consumers cut back on outside entertainment like dining out and going to the movies but kept lower-cost "home comforts" like movie rentals, so Netflix could actually benefit in such a case.

Netflix should be a good 2012 play, with room to run to at least $130 a share. If it does suffer a near-term pullback, consider that an opportunity to pick up the stock at a discounted price.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.